– It appears that the sector is evolving into a case of the “haves” and “have nots.”

By Mary Diduch

National Real Estate Investor – Dec 2017

Conventional wisdom posited that grocery-anchored shopping centers would be immune from the Amazon effect. While that might be the case for now, industry insiders say grocers need to adapt—not just in light of a potential threat from e-commerce players, but also because of the increasing number of competitors in the space.

So far, online shopping—while taking a toll on department stores and the brick-and-mortar apparel retailers in particular—has not hit grocery stores as hard. Recent analysis from Morningstar Credit Ratings, which focused on Campbell’s soup, noted that online purchasing of grocery products hasn’t gained a lot of traction: it accounts for “a low-single-digit percentage of total sales.”

Still, the report notes that this percentage could increase as consumers become more comfortable with buying food online and predicts that U.S. online grocery sales will grow 18 percent to $14.2 billion this year—the same pace as last year. Given the growth of meal kit services and Amazon’s foray into the space with its acquisition of Whole Foods, online grocery sales could increase to 23 percent in 2018 and 26 percent the year after, according to Morningstar.

This uncertainty has started to sink in for investors in grocery-anchored shopping centers. “I think there’s certainly more unease in the marketplace today than there was two or three years ago, as investors have begun to realize there’s going to be more disruption in grocery retail than people realized,” says Joseph McKeska, president and co-founder of Chicago-based Elkhorn Real Estate Partners, a division of New York based A&G Realty Partners which provides advisory and investment services to grocery-anchored landlords.

Still, those who work in the sector say the fundamentals continue to be strong.

“We’ve seen cap rates and valuations stay the same over the past year or two” for high-quality centers with good tenants, with a widening of rates in lower-quality centers, says Matt Kopsky, a REIT analyst at Edward Jones who covers shopping center REITs Kimco Realty Corp. and Weingarten Realty Investors.

However, there have been few recent transactions in the space lately, making it hard to determine where cap rates are moving, particularly as prices in other retail sectors—such as malls and power centers, for example—have taken a hit, says Jeffrey Edison, president and CEO of Phillips Edison & Co., a grocery-anchored REIT. Despite these questions, Edison continues to see the future as healthy, though there may also be continuing constraint in terms of new development in the space. “We believe existing centers on the grocery-anchored side will continue to have really strong operating fundamentals, which we have right now,” Edison notes. “I don’t see a change for that in the near future.”

Ross Cooper, president and chief investment officer at Kimco Realty, a REIT based out of New Hyde Park, N.Y., says he has continued to see aggressive pricing in some parts of the sector, particularly in gateway and coastal markets. “In some places, we’re seeing cap rates [of] sub-5 percent,” Cooper notes. The assets that are attracting the most interest tend to be located in major markets and feature strong tenants who are accomplishing well above-average sales per sq. ft.—a trend Cooper expects to continue heading into 2018. “So long as interest rates remain historically low, I think there will be a strong demand for this type of product.”

Still, it appears that the sector is evolving into a case of the “haves” and “have nots.” Institutional investors with centers with strong grocery anchors in primary markets tend to be faring better, with little pricing changes, while owners of core-plus or value-add properties with weaker tenants are facing more difficulties, says McKeska. “There seems to be a growing concern about the risk associated with some of those assets,” he notes. In the top five markets in the country, cap rates have remained in the 5 percent range, but they rise to around 6 percent in the next 25 markets on the list and above that for markets out of the top 100, Edison notes.

While the acquisition of Whole Foods by Amazon has some wondering whether grocery delivery or click-and-collect services will become the norm, there are some categories within the sector that will likely remain immune to such influence, McKeska says. “If you’re talking about fresh foods, fresh prepared foods in particular, you’re going to see a much smaller impact,” he notes.

The evolution in the sector has caused Phillips Edison & Co. to shift its perspective as well. Historically, the REIT looked at core and core-plus properties, but now, the company is looking at opportunistic buys more than it had in the past, as well as at power centers with grocery tenants, Edison says.

There also has been tougher scrutiny of grocery tenants. “Today tenant quality is becoming increasingly paramount in retail,” says Alan Esquenazi, principal at Florida-based CREC, a real estate services firm, noting that the health of grocers and their ability to adapt to e-commerce threats is more important than ever. In Edison’s view, Kroger and Walmart are the top grocers in terms of providing click-and-collect services, though other grocers are working toward expanding their omni-channel offerings. “Everyone’s trying, but they have—so far—the biggest distribution,” he notes.

In the long term, it is likely there will be continued store closings in the shopping center space, particularly at lower-quality centers, Kopsky says. On the other hand, changes in the sector have in some cases led to new opportunities. For example, ShopOne, a private grocery-anchored shopping center REIT headquartered in New York City, launched in October. Michael Carroll, ShopOne’s CEO, says some of the negative headlines surrounding retail at large have helped to reduce competition in the grocery-anchored space. With ShopOne, he says he has found more acquisition opportunities in the sector that may have been too competitive 24 months ago. “It’s reduced the number of buyers chasing quality assets,” he says.

In Carroll’s view, e-commerce competition will not eat up significant market share in the grocery sector. Instead, the focus has been on the rise of specialty and discount grocers, which has led to less store growth among traditional grocers, he notes.

McKeska agrees. Disruption is happening through different channels, including the expansion of home meal kit solutions, as well as specialty retailers, he notes. “Those retailers who have both strong business models that they continue to improve upon and the capital and the capabilities to expand their offering … I think are ultimately going to be successful,” he says.